Two of the credit options many people consider is an overdraft and a personal loan. The question is, which is better? A personal loan or an overdraft facility? What situation would suit each option better?

Personal Loan or Overdraft - Which is Better?

Oct 17, 2019

Credit can be an empowering financial tool. It helps you in many different ways. You can finance business projects, cover unexpected costs, buy a house and cover the shortfall of a tough month. But finding the right credit option can be difficult! Using it correctly can be an even trickier thing, so you need to make sure you make the right choice at the start.

Two of the credit options many people consider is an overdraft and a personal loan. The question is, which is better? A personal loan or an overdraft facility? What situation would suit each option better? We’ll assess each of the two by looking at their pros and cons.

After reading this article, you will be able to choose which option suits your needs better. If a personal loan is the way for you to go, get started and compare options by clicking here.

What is a Personal Loan?

Before breaking down the pros and cons of personal loans, let's quickly look at the main components that make up a personal loan. You have the following four things you need to understand:

  • Principal amount – This is the original amount borrowed from the lender.
  • Interest rate – This is the interest you are given and it accumulates on the borrowed amount as time passes. Along with time, this is what causes the debt you will owe and pay back in time.
  • Set loan period – The predetermined amount of monthly repayments or months over which you pay back the debt (with interested on it).
  • It is usually unsecured – You don’t need to provide an expensive asset as payment when you can’t repay the loan.

Did you know? Interest rates calculated over a certain time period is what allows financial situations to make an income from lending you money.

How can you generally use a personal loan?

You can use a personal loan for whatever you want to. Whether you use it responsibly, is another question and one you can hopefully answer positively.

To get a personal loan, you need to confirm whether you are eligible for one and apply for the amount you need. Your credit score determines whether you get approved for a loan and it also has an effect on the interest rate applied to it. You need to repay it with set monthly payments. In some cases, you may repay larger amounts without a prepayment penalty. Ask the lender if this is possible before you do it.

Here follows a selection of the pros and cons of a personal loan.

Pros

  • Fixed interest rate – Choose a fixed interest rate personal loan and pay a fixed monthly instalment.
  • Set principal amount – The loan amount can’t be increased. You can’t borrow more on the same loan and end up overspending on unnecessary things.

Cons

  • It’s hard to borrow more on the same loan – You don’t have access to more money on the same loan. You’ll have to apply for more at the lender.
  • Missed payments damage your credit score – Your credit score lowers when you miss personal loan payments.

What is an Overdraft Facility?

You now understand what a personal loan is. But what about an overdraft facility? Let’s look at the main characteristics of an overdraft facility.

  • Overdraft facility - This is a credit facility attached to your current transactional account.
  • Ease of usage - It only engages when activated and you spend more than the available balance in your account.
  • Maximum limit - An overdraft has a maximum limit beyond which you can’t spend. This limit is usually a limit you apply for.
  • Interest rate - It has an interest rate (it may be a variable rate).
  • Repayment method - You repay it as money gets deposited into your account.

An overdraft is a handy tool. It allows you to spend more than what is actually in your bank account. To get an overdraft facility, you need to first open a bank account with a bank that offers the service. Apply, get it approved and it should be available to you whenever you need it. Different banks have different costs and fees on their overdraft facilities.

Some overdraft facilities have fixed interest rates and others have variable rates. If you work smart, you might get one that has a pay per use structure. This helps to lower the credit cost since you only pay for it when you use it. That being said, let’s look at the pros and cons of an overdraft facility.

Pros

  • The overdraft available on your current account – You can’t really “miss” a payment. Only when you max out your overdraft limit will you miss payments.
  • Cover unexpected costs immediately – Once it is available you can use it as you please. You don’t need to ask the bank when you want to go into your overdraft.

Cons

  • Possibly overspending – It’s easy and tempting to overspend.
  • Variable interest rates – Overdraft facilities often have variable interest rates. It could possibly increase the required payments when the Prime Rate is increased.
  • Difficult eligibility requirements – Banks only allow people with good credit scores to get an overdraft facility.
  • It’s connected to your account – A negative balance automatically takes from the money paid into your account.
  • Limited amounts - an overdraft limit will rarely give you the big numbers a personal loan does.

Which option is better?

We know it’s a frustrating thing to hear, but it really does depend. Each option has a better situation compared to the other. Below we will give you some ideas on when one can be better than another.

The personal loan may have fewer cons than an overdraft facility, but that doesn’t mean it’s better. These two credit options are very similar, but it’s hard to compare the two. Each of these options has different uses. They work best in different situations.

When to Use a Personal Loan

A personal loan is a great tool with which to finance a project or personal need. You get the money you need and repay it in monthly instalments. You know what you need to pay and you can’t increase the loan without a new loan agreement. Here are possible scenarios in which a personal loan is better than an overdraft facility.

  • When you need credit but can’t trust your spending habits with an overdraft.
  • When your credit score is not good enough for an overdraft.
  • When the interest rate on a personal loan is lower than an overdraft facility (and the amount required will only take a few months’ repayments).

When to use an Overdraft Facility

Overdrafts serve an awesome purpose. You don’t have to worry about debit orders when your overdraft facility can cover it. The money is available immediately. Here are situations in which an overdraft is a better option than a personal loan.

  • When you regularly need small amounts beyond your current account. balance (and you can repay it before interest becomes a problem)
  • When you experience small cash flow issues due to the timing of your income versus fixed expenses.
  • When the overdraft interest rate is lower than personal loan rates.

Conclusion

It’s difficult to compare apples and pears. Both may be fruit, but they are so different! It’s the same with comparing a personal loan and an overdraft facility. Both are a form of debt, but they have different characteristics.

Yet we have seen today, it’s possible to find the better option. Your situation determines which of the two are the best. Assess your needs according to the scenarios listed above and choose the best option for you.

If you have found that a personal loan is what you need, click here to apply and get personalised offers based on your credit health.

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